Rising Consumer Debt Portends A 10% Correction In This Market

The evidence points to consumers who are either genuinely broke or living beyond their means.

Of late, the market has been on quite the run. As I write this, the S&P 500 is up some 13.8% YTD and the Nasdaq an even more astonishing 29.7%! As it happens, most of these gains have come from a very small subset of stocks. Still, quite frankly, readers of my work know that this has come as quite a surprise to me.

I could write about a lot of things in this article, including the fact that, while the Fed took a break this last go-round in terms of raising interest rates, Jerome Powell made it clear that two further hikes this year are likely in the cards. Given how the market has exploded upwards since that pause, skip, whatever you want to name it, I don’t see any reason to believe the Fed will change its mind.

However, I am going to feature something else that concerns me, rising consumer debt. First of all, let me start with the latest iteration of something I have featured in previous articles, the New York Fed’s Household Debt and Credit Report.

Here, from the PDF version of the complete report, is the headline graphic listing the breakdown of the latest figures.

New York Fed - U.S. Household Debt & Credit Report

During the quarter, total household debt broke the $17 trillion mark for the first time, rising by $148 billion, or 0.9 percent, to $17.05 trillion. Mortgage balances climbed by $121 billion and stood at $12.04 trillion at the end of March. Auto loan and student loan balances also increased to $1.56 trillion and $1.60 trillion, respectively, but credit card balances were flat at $986 billion. On that last point, the report notes that credit card debt typically falls during Q1, so the fact that it held flat could be considered somewhat of an anomaly.

The Question Is: Why?

Here is where I want to dig a little deeper in this article. I have been struggling to answer the question as to why this is occurring. For those fortunate enough to be able to invest in the markets, the returns have been strong. Further, the tremendous stimulus unleashed during the pandemic led to the U.S. household savings rate being stronger than it had been in years! Why is it, then, that U.S. household debt continues to rise? Wouldn’t it have been wise to pay down some of this debt?

The answer appears to have to do with a combination of the effects of inflation as well as lifestyle choices. Recently, a Wall Street Breakfast article on Seeking Alpha, a publication for which I also write, made this observation:

Driving the spike: High inflation is pushing more consumers to put non-discretionary spending on cards, while others may be having a harder time paring back their lifestyles despite the price pressures. Interest rates are compounding the issue, with the average annual percentage rate now over 20%, making it a really costly debt for consumers.

Likely you caught the two themes. The first one makes sense to me, that many families are genuinely struggling. But it was that second theme that really caught my attention. Namely, that others have become used to a certain lifestyle but are now having to rely on debt to support that lifestyle. Interestingly, that was what I had been thinking all along.

Yesterday, I came across an article in The New York Times entitled Is the Inflation Battle Won? Not Yet. If I have done things correctly, here is a gift link to the article, as a gift to my readers. It stopped me in my tracks, as it offered a real world account of that concept in action.

The article featured Cylus Scarbrough, 42. Mr. Scarbrough works as an analyst for a homebuilder in Sacramento. His skills are in such high demand that he received a 33 percent raise when he joined his present company two years ago, and his income has climbed even further since then. Compounding this good fortune, he bought a house just at the start of the pandemic and now has about $100,000 in equity.

Here is how the article describes Mr. Scarbrough’s current situation:

Even so, he’s racking up credit card debt because of higher inflation and because he and his family spend more than they used to before the pandemic. They have gone to Disneyland twice in the past six months and eat out more regularly.

“It’s something about: You only live once,” he explained.

He said he felt OK about spending beyond his budget, because [of the equity in his home]. In fact, he is not even worrying about inflation as much these days — it was much more salient to him when gas prices were rising quickly.

“That was the time when I really felt like inflation was eating into our budget,” Mr. Scarbrough said. “I feel more comfortable with it now. I don’t think about it every day.”

In this, we have an example of a family who has actually done very well economically of late and, despite this, apparently still feels the need to take on debt to support a desired lifestyle.

In April, my wife and I traveled to London and Italy, in celebration of our 40th anniversary. At every step along the way, we ran into crowds of American tourists, enjoying the freedom to travel after being hemmed in by COVID for so long. From what I am able to read, the expectation is that this will only be increasing through this summer, and that the prices for such trips are escalating as a result. I suspect that at least some will be paying for these trips with credit card or similar debt.

Something’s Got To Give

The only question is: Is this sustainable? As Ray Dalio features in his excellent video How The Economic Machine Works, debt allows one to live beyond one’s income for a period of time, or “spending beyond one’s budget” as the article above features Mr. Scarbrough doing. However, this cannot continue indefinitely. Repaying that debt, at some point, requires the opposite; living below one’s income. In turn, this curtails spending which, in turn, curtails the income of someone else in the economic chain.

All of this, potentially combined with further increases in interest rates, would seem to portend a coming slowdown. To go a step further, while Mr. Scarbrough apparently has $100,000 in equity in his home today, even this is by no means guaranteed. For a variety of reasons, home prices have shown remarkable resilience, at least in certain areas. But continued high interest rates may make this unsustainable.

One last detail to ponder. Another bedrock component of pandemic-era relief for households is coming to an end: The debt-limit deal struck by the White House and congressional Republicans requires that the pause on student loan payments be lifted no later than Aug. 30.

In combination with other factors, I find myself in agreement with the viewpoint that we may experience at least a 10% correction in the markets somewhere during the second half of 2023 before we may be able to get to a sustainable long term uptrend.

All of this, hopefully, gives further clarity to my most recent article here at Substack. In this article, I suggest that it may be prudent to maintain a higher-than-usual allocation to cash and bonds at this present time. For any of my readers who have not yet had the chance to consider this, here’s a handy link.

I’d love to hear your comments below. Are you in agreement with what I am presenting in this article? Or do you see things differently and, if so, why? I am certainly interested in all viewpoints, because we’re all in this thing together.